Investing to become wealthy is different than investing to preserve wealth.
A lot of financial articles are written for those who want to preserve wealth. If your investment objective is to become wealthy, here’s what you need to know.
For the last 10 years, the risk-free interest rate has been less than the inflation rate. If your objective is to become wealthy, you need a better return than the risk-free interest rate which means you have accept some risks. However, you have a choice of which risks to take.
Broadly speaking, it is useful to divide risks into two buckets; market risks, and company risks.
Market risks are those that affect all stocks. Two good examples are monetary and fiscal policy. When monetary and fiscal policy is conducive to a strong economy, the market can deliver excellent returns. However, the opposite is also true. When monetary and fiscal policy is headed in the wrong direction, the economy shrinks, and the market falls.
Company risks are those that affect only one company. A biotech company’s clinical trial is a good example. Depending on the trial’s outcome, the company’s stock can double or lose half its value overnight. Whatever the outcome, however, the value of other stocks will be unaffected.
At this point, let me ask you a question. Are you comfortable that today’s fiscal and monetary policies are conducive to a strong economy?
I do not need to know whether you support or oppose today’s policies. What matters is whether you are comfortable with today’s market risks because if you are, a passive investing approach makes sense for you.
If you are not comfortable with today’s market risks, then you either need to have a very long time horizon, or you need to consider accepting some company risks by investing in individual stocks.
Let’s discuss the importance of your time horizon. Over the last 90 years, the market has averaged about 10% a year. This does not mean that you can expect an index fund to return 10% each year. In fact, there have been many years in which the market lost money.
However, if you have more than 20 years, the odds of losing money in the market go way down, and the odds that you’ll have a positive return that can slowly make you wealthy improve significantly. This is the approach that many have chosen but it is not necessarily your best option particularly if you don’t have 20 years.
The alternative is to invest in individual companies. Even if the market is down, some companies will deliver so much value to their customers that they can grow and deliver a good return for investors.
Unfortunately, there is no benchmark and thus no index fund that invests in just these companies. To choose this path, it makes sense to use a manager who has a long and impressive investment track record, at least in sectors that don’t overlap with your own stock picks.
There are a few great mutual fund managers. Out of 6,915 U.S. equity mutual funds in Morningstar’s database, 1,806 have managers with 10 years of tenure, but only 199 of them have beaten the S&P 500 and outperformed their category benchmark over the past 10 years. I wrote about them in February, and you can download a spreadsheet that lists them all.
However, by and large, most mutual fund investors are getting managers whose track records are either too short or not significantly better than their benchmarks. I think a primary reason why so many people’s portfolios have not performed well is that too many mutual fund managers are unproven.
I have long believed that there are more great investors like Warren Buffett, who work outside of the mutual fund industry, and I have devoted a great deal of effort to find them. Forbes recently published the story of Dr. Herbie Wertheim, an optometrist who is one of the greatest investors you’ve never heard of. In addition to Buffett and Wertheim, I would add Wayne Himelsein and Tony Mitchell to the list. Let me tell you why.
Quantitative investing has become all the rage. But I have been watching Wayne Himelsein hone his investment algorithms for more than 18 years.
A lot of quant algorithms work great on historical data. The problem is that the future is never exactly like the past. I would say, almost without exception, that algorithms that work well on historical data don’t work as well going forward.
Because of this, quants are always fiddling with their algorithms, increasing or decreasing the weight of this or that factor, to get a better result.
No quant I know of has used the same algorithm for more than a couple of years. For this reason, I’ve never come across an algorithm with a long enough track record to evaluate it.
However, although algorithms change, as long as the manager stays constant it is possible to evaluate the skill of the manager.
Over 18+ years — through the tech bubble, the financial crisis and corrections to numerous to count — Wayne has averaged 11.99% a year, more than double the S&P 500’s 5.92% return over the same period. Moreover, Wayne’s return is after deducting 1.95% a year for management fees while the S&P 500 return is before any fees.
When I started watching Tony Mitchell in 2000, there were a lot of internet mutual funds that invested in companies that didn’t have revenues, much less profits. In contrast, Tony’s strategy has been to invest in “companies with great products and great brands that show promise of continued growth.”
By focusing on a technology’s value to the customer, instead of the technology itself, Tony’s portfolio has adapted as each wave of tech companies found new ways to benefit customers.
Investing in companies that create value by serving their customers better than anyone else is the essence of Buffett’s investment style. Tony applies this strategy to find companies that use technology to increase their value to their customers.
Tony has been running an Internet Fund at Marketocracy for more than 18 years that has averaged 17.17% a year (again after deducting 1.95% a year in management fees), almost triple the S&P 500’s return of 5.97% over the same period.
If you are comfortable with today’s market risks, and you have a long time horizon, indexing is a good way to build wealth slowly.
If you are not comfortable with today’s market risks, there are still companies worthy of an investment. However, there is no index fund that invests just in these companies. To go down this path, use managers with excellent long-term track records at least until you develop your own investing skills.
This article is part of a series I write for those who want to get their portfolios back on track. To be notified when the next installment is published, click here.
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